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FCA warns consumers over risks with initial coin offerings

UK consumers have been warned against investing in 'initial coin offerings' (ICOs) by the Financial Conduct Authority (FCA).12 Sep 2017

The regulator advised consumers only to invest in ICOs if they are experienced investors, prepared to lose their "entire stake", and can be "confident in the quality of the ICO project itself (e.g. business plan, technology, people involved)". It described ICOs as "very high-risk, speculative investments".

ICOs are an increasingly popular way for businesses to raise money.

Typically, businesses will develop a digital token, such as their own proprietary virtual currency, and look to sell those tokens to investors in a bid to raise capital in return for existing cryptocurrency, such as Bitcoin, Ether or Ripple rather than fiat currency such as dollars, euros or pounds. The trade of these tokens is recorded using blockchain 

Investors can in most cases sell on those tokens for profit on certain peer-to-peer exchange platforms should the value of the tokens increase. They are sometimes further incentivised into buying the tokens by being given the opportunity to share in profits generated from the business ventures that benefit from their investment.

In a new statement published on its website, the FCA warned, however, that it does not regulate most ICOs, with many based overseas, and that UK consumers are "extremely unlikely to have access to UK regulatory protections like the Financial Services Compensation Scheme or the Financial Ombudsman Service" should they choose to invest in such schemes.

The risk warning also highlighted price volatility and the potential for fraud in the ICOs market, and said prospective investors may be presented with "unbalanced, incomplete or misleading" information about the ICO they are being encouraged to invest in and would not receive a "regulated prospectus" which would highlight risks involved in investing to them.

"A sophisticated technical understanding is needed to fully understand the tokens’ characteristics and risks," the FCA said. "Typically ICO projects are in a very early stage of development and their business models are experimental. There is a good chance of losing your whole stake."

The rise of ICOs has prompted a regulatory response from a number of financial authorities around the world, including those based in the US, Hong Kong, Singapore and China. Prior to its latest statement, however, the FCA had only addressed the topic briefly in a discussion paper on distributed ledger technology it published in April.

In the paper, the FCA specifically asked firms to detail the legal and regulatory challenges they find "in fitting initial coin offerings into our regulatory framework". The FCA did not provide much in the way of its own views about how existing regulation is engaged by ICOs, but did state that ICOs could "fall into the regulatory perimeter" depending on "how they are structured".

In its latest statement, the FCA restated that the regulation of ICOs in the UK "can only be decided case by case".

It said: "Many ICOs will fall outside the regulated space. However, depending on how they are structured, some ICOs may involve regulated investments and firms involved in an ICO may be conducting regulated activities. Some ICOs feature parallels with Initial Public Offerings (IPOs), private placement of securities, crowdfunding or even collective investment schemes. Some tokens may also constitute transferable securities and therefore may fall within the prospectus regime."

"Businesses involved in an ICO should carefully consider if their activities could mean they are arranging, dealing or advising on regulated financial investments. Each promoter needs to consider whether their activities amount to regulated activities under the relevant law. In addition, digital currency exchanges that facilitate the exchange of certain tokens should consider if they need to be authorised by the FCA to be able to deliver their services," it said.

Expert in financial services and technology Luke Scanlon of Pinsent Masons, the law firm behind Out-Law.com, said some of the FCA's messaging could be construed as positive for businesses considering ICOs, but that further detail is required to clarify the regulatory position in the UK.

"What stands out to me in all of this is that while the FCA has made it abundantly clear that ICOs can be high risk, it has also made statements that may be taken as indications about the future of ICOs," Scanlon said. "Comments such as 'many ICOs will fall outside the regulated space' and 'you are extremely unlikely to have access to UK regulatory protections like the Financial Services Compensation Scheme or the Financial Ombudsman Service' are not firm affirmations that investors will not have recourse to regulatory protection."

"Given the recent explosion in ICOs it is understandable that the FCA has produced a one-page statement. However, those seriously investigating their future as a means of raising funds and investing will need to wait for the regulator to publish a more detailed analysis of the nuanced questions it raises or asks investors to consider, before moving forward with a sufficient amount of certainty," he said.